Leverage With Minimal Risk

Madoff insists that rather than the pursuer, he was usually the pursued. People begged him to take their money. Madoff says that he waved red flags, issued caveats that should have been obvious to even an unsophisticated investor. “They were all told by me, ‘Don’t invest any more money than you could afford to lose. This is the stock market. There’s always stuff that can happen. Brokerage firms can fail. I could go crazy and do something stupid. If you want a [safe thing], put your money in government bonds. So everybody understood this.

“Everyone was greedy,” he continues. “I just went along. It’s not an excuse.”

Interview with Bernie Madoff in this week’s New York Magazine.

Here is the brutal truth about the FX market. Dealers do not need to shade prices, freeze quotes, run your stops or perform a thousand other nefarious tricks in order to make money. All they need is the natural ebb and flow of the market and leverage will do the rest. At 10:1 lever factor just ten consecutive 1% stop outs will blow out your account. At 20:1 just five wrong trades with a 1% stop will destroy all of you capital and at 100:1 lever factor you have just one chance to get it right.

Little wonder then that the vast majority of all traders lose most of their money within three months of trading FX. Industry PR portrays leverage as an opportunity as well as a risk (it can work for you or against you) but in my opinion it is the crack cocaine of the financial markets. I believe that leverage -- not market analysis -- is the single greatest reason for trader failure. The longer I trade the less I lever up. I use a very boring equity like 2:1 lever factor. It may not be thrilling but it is effective. My drawdowns have declined markedly and my equity has seen a steady climb higher.

Most of us understand on an intellectual level that leverage is dangerous, but we employ it anyway. Why? Because like Madoff’s investors we are greedy beyond belief. Many retail traders come into the FX market expecting to turn $10,000 into $100,000 by year end -- that a 1000% return. Such traders would be better off buying a lottery ticket, which at least will provide them with a colorful piece of paper as a souvenir of their folly. 1000% return expectations are absolutely absurd. If you are an occasional trader 20% per annum should be considered a great year. If you trade actively everyday like a prop trader 50%-100% on your capital is the maximum you can realistically expect to achieve -- if you have a good analytical edge and steely discipline. (Two huge IFs for most traders)

Although excessive borrowing on your capital is always a bad strategy, there is another way to achieve leverage with minimal risk. As every retailer will tell you can get leverage on your capital through turnover. If you flip your inventory 10-20 times per year, you will be able to lever your capital without any actual borrowing.

As intraday traders we flip our inventory several times a day even if we trade on 1:1 leverage. Typically I trade between 6-10 times per day, so my own rule of thumb is to risk about 25 basis points of my equity on any one trade. This way if I have 8 losing trades in a row I am down 2% for the day -- a reasonable loss from which I can recover. On those trades when I just want to play or experiment with the market I use my 10% rule and basically risk 5 basis points per punt (yes I know that’s actually 20% but its close enough to keep me out of trouble).

My trading goals are really quite simple. If I can earn an average of 50bp/day on my capital, control my drawdowns to no more than 2% and keep my equity on relatively even keel -- I am very happy with my results. Most importantly, I am never at the mercy of the market or the dealer and I maintain control over may capital. So next time you decide to lever up I have one word of advice -- DON”T.